Weighing the costs of cooling down inflation

By
David R. Francis /
April 8, 1980

Boston

Is it worthwhile fighting inflation with a recession? That may seem almost a redundant question currently. The Carter administration has in effect abandoned the concept of a modest slowdown to battle inflation. It and the Federal Reserve System have chosen to force a serious recession on the economy to slow down the rise in prices. Indeed, that recession may already have started.

However, two economists, Laurence H. Meyer and Robert H. Rasche, analyze the costs and benefits of anti-inflation policies in the current issue of the Review of the Federal Reserve Bank of St. Louis.

The two review the results of several econometric models that project the costs of tackling inflation through lost output resulting from a recession. The cost estimates for getting an underlying rate of inflation from 7.5 percent to zero vary dramatically -- from virtually nothing to $1.8 trillion.

Mr. Meyer, in a telephone interview, guessed that both extremes are probably unlikely. He figures that $600 billion to $700 billion would be "a kind of useful intermediate." That would be spread over 8 to 10 years.

That is obviously expensive. Such estimates are the basic reasons why such economists as Barry M. Bosworth, formerly looking after President Carter's wage and price guidelines program, now advocates a wage and price freeze and formal controls. The anti-inflation struggle with classic monetary or fiscal policy actions isn't worth the economic suffering, he argues, in effect.

But that position depends on the costs of inflation. If the costs of inflation are worse than the costs of licking it, then the anti-inflation policy is logically justifiable.

Here, however, economics is even more at a loss than in estimating the lost output from anti-inflationary recessions. In fact, there are practically no numbers around.

Nonetheless, there certainly are costs. Messrs. Meyer and Rasche list some. One is what can be labeled "menu" costs. It cost time and money to frequently revise price lists or catalogs in an inflationary economy. For instance, Keith M. Carlson, an economist at the St. Louis Fed, says his daughter was employed full time at a discount store as a "price change captain," in charge of a staff revising prices on the store products.

Another item is termed "shoe leather costs." With prices rising rapidly, there is an incentive to go more frequently to the bank or the market to economize on currency holdings. Individuals don't want to hold on to money long when it is losing value rapidly. They want to keep it invested or busy buying goods.

But there are more serious costs of inflation. Because of the structure of the tax system, it tends to discourage savings and investment in productive plant and equipment. With inflation running at 18 percent today, it doesn't pay to put your savings in a bank savings account paying perhaps 5.75 percent. It loses money in real terms. Then that interest income is taxed.

Mr. Carlson suspects that the poor gains in productivity in the United States in recent years are closely related to the high inflation rate. It becomes more risky for businessmen to calculate the return they will get on an investment in new machinery or equipment.

Messrs. Meyer and Rasche also point to the tendency for inflation to redistribute income and wealth. It changes the rules of the economic game in ways that benefit some and hurt others. Often the changes are unjust. It causes social and political turmoil.

Moreover, inflation damages the nation's financial institutions. These were designed primarily for relatively stable prices. Now inflation has changed the environment. Thus congress has had to change the banking laws to adjust to inflation. Bank regulators have decided to permit variable rate mortgages. All this takes time and money.

Instead of concentrating on being more efficient and more productive, many people divert their efforts to beating the inflation game. It is a great waste of effort from the national economic standpoint -- though not necessarily from the individual's position.

So is fighting inflation worthwhile?

"My guess is that the costs of inflation may be large enough that it could well be socially optimal to follow the restrictive monetary policies that would substantially eliminate inflation," says Mr. Meyer, an economist with Washington University in St. Louis.

But he doesn't really know. "Narrowing the range of estimates of output loss and developing a measure of the benefits associated with anti-inflation policies should be high on the priorities for macroeconomic research in the 1980s," he and Mr. Rasche suggest.

Actually, considerable research in these areas is already under way by such bodies as the National Bureau of Economic Research.

Professor Meyer doesn't approve, however, of the "quick fix" approach of wage and price controls. History shows these do not do the job, he argues.

Whatever, the nation is becoming fed up with inflation. Seeing this, President Carter and the Fed are embarked largely on the traditional inflation cure of recession. It does, with a lag, eventually trim inflation. But it is costly and slow and requires the Fed to persistently restrain the growth of money over years.